Have No Fear, Muni-Bond Investors

State and local governments face their biggest budget shortfalls since the Great Depression. Alabama’s Jefferson County recently displaced Orange County, Calif., for the dubious distinction of the largest municipal bankruptcy in U.S. history. Vallejo, Calif.; Stockton, Calif.; and Harrisburg, Pa., have likewise made the news for missing debt payments.

It’s enough to make muni investors just give up.

But that would probably be a mistake. As bad as the fiscal picture is for scads of states, counties, cities, towns and villages, the $3.7 trillion municipal bond market still offers opportunities for yield, total return and, yes, safety — as long as you invest wisely (for example, in general obligation bonds) and diversify, diversify, diversify.

It’s important to note that even as Jefferson County went bankrupt — and other local governments defaulted on debt payments — the municipal bond market has remained remarkably resilient. The Barclay’s Capital municipal bond index delivered a total return of nearly 11% in 2011. Only Treasury Inflation-Protected Securities (TIPS) and U.S. corporate junk bonds performed better in the U.S. credit markets last year.

For this year to date, muni bonds are up 1.49% at a time when almost all U.S. government is negative for 2012. Indeed, the longest-dated Treasury bonds have plunged nearly 8% so far this year.

When Jefferson County declared bankruptcy in November, the muni-bond market hardly flinched — and there’s a good reason for that, notes Rob Williams, director of income planning at Charles Schwab‘s (NYSE:SCHW[1]) Center for Financial Research.

“The ‘silent majority’ of municipalities in the large, diverse municipal-bond market have demonstrated great resilience in the face of steeply declining tax revenues,” Williams writes in a note to his clients.

As painful (and often devastating) as budget cuts have been for communities, state and local governments have been sharply cutting back for more than four years, note Williams and Kathy Jones, a fixed-income strategist at Schwab. Since 2008, state governments have successfully closed budget gaps of more than $530 billion, according to data from Standard & Poor’s.

“Unlike the federal government, 49 of the 50 states and most local municipalities are required by law to balance their budgets annually,” Williams and Jones write. “This has been tough for local stakeholders and the economy. But it’s also been a demonstration of support for muni bonds.”

But while the longer-term outlook for the wider muni-bond market appears positive, there could be some short-term hiccups, notes the municipal-bond management committee at BlackRock (NYSE:BLK[2]).

“The fundamental backdrop generally appears healthy, but it requires monitoring as budget season approaches and select credit stories begin to capture headlines,” BlackRock writes in a new report to clients.

The bond managers remain constructive on the market but mindful of the fact that muni-bond prices could fall in the near term as headline risk develops. Still, tax-exempt bonds remain attractive relative to their taxable counterparts and “should continue to benefit from the burgeoning interest of a diverse and growing set of investors,” BlackRock says.

For investors who remain committed to tax-free munis, the key is to “stick with quality and choose wisely,” say the Schwab analysts. Consider bonds backed by stable sources of revenue or state general-obligation bonds where there are legal protections for bond holders.

Most important: diversify. Schwab recommends that no more than 10% of your fixed-income portfolio be exposed to any single muni-bond issuer.